Is It Time To Increase Allocations To Foreign Securities?

March 25th, 2015

By: Philip Weiss, CFA , CPA | Chief Investment Analyst

Does what goes down come back up? Investors who practice asset allocation answer this question affirmatively every time they rebalance their portfolio. After all, asset allocation is primarily based on the idea that investors should reposition their portfolio periodically by re-allocating funds from the best-performing asset classes to the weakest ones. Over time, it is assumed that the returns of the strong performers will fall to their long-term averages while those of the weakest performers will rise closer to their long-term averages (a concept referred to as reversion to the mean).

More recently, some have questioned this approach, as domestic markets have delivered exceptional results. In fact, according to Morningstar, over the last five years, the average moderate allocation fund (invests in domestic stocks and bonds) out performed the average world allocation fund (invests in stocks and bonds anywhere in the world) by an annualized 2.1%, implying that diversifying into foreign stocks has not helped investors.

But the outcome is a bit different if we review longer periods. Over the past 10 years, the average world allocation fund has outperformed the average moderate allocation fund by 2.3% on an annualized basis. Over the last 15 years, returns for the average world allocation fund have surpassed those of the average modest allocation fund by a modest 0.1% annually.

As discussed in last quarter’s Advisor, the US Economy looks poised for another strong year in 2015; the near-term outlook for most foreign economies seems far less robust. The stronger U.S. economy has helped drive the U.S. market’s strong returns. Returns from U.S. stocks have also benefited from the Federal Reserve’s consistent commitment to ultra-easy monetary policy since the financial crisis of 2008. At the same time, the outlook in Japan remains muddled at best and growth in emerging nations such as China has slowed. Other countries like Russia and Brazil have been hurt by the weakness in commodity prices and high inflation at home.

IMPROVED OUTLOOK IN EUROPE

In 2014, European stocks delivered disappointing returns. However, while there are still reasons to remain concerned about the ultimate resolution of the situation in Greece, the outlook has improved. Oil prices are down significantly from the highs they achieved last summer, the European Central Bank has initiated a quantitative easing program, and the euro has weakened relative to the US dollar. The combination of these factors constitutes the most significant easing of financial conditions in the eurozone in more than a decade. In addition, the region’s economic data is showing positive signs as the rate of GDP growth has edged higher for the past two quarters; expectations are that economic activity will continue to strengthen as the year progresses.

At a minimum, this supports the argument for remaining invested in international equities. If economic growth in the U.S. surpasses expectations, the U.S. stock market will likely continue to do well. But, at some point, it is equally likely that the tide will turn, and international equities will deliver stronger gains.

RECENT PERFORMANCE

Over the past four years, the profits of U.S. stocks in the S&P 500 have compounded by 11% annually, while profits of European stocks, as measured by the MSCI European Index, have compounded at -6%. During this period, economic growth in the U.S. has been much stronger than in the eurozone. This divergence in economic growth has been reflected in the performance of these indices as the S&P 500 has increased at an annualized rate of 16.0%, easily surpassing the 6.8% annualized return of the MSCI European Index over the same period.

SOME HISTORICAL PERSPECTIVE

Based on research by GMO (a nationally renowned asset manager whose strategies are based on asset allocation), the 20% of developed stock markets that outperformed the most over a three-year period, lagged on average by 1.3% in the following year and by 2.4% annualized over the next three years. The worst 20% of prior performers outperform by 1.6% and 0.8% annualized, over the same respective periods. In short, when a market outperforms over a three-year period, it is likely to underperform over the next one and three years. Similarly, if a market underperforms over a three-year period, it is likely to outperform over the next three years.

CLOSING THOUGHTS

Those investors who fear volatility may also be better served by investing in foreign equities. As a general rule, foreign stocks do not move in lock step with U.S. shares. Adding foreign shares to your portfolio can reduce the overall price gyrations within your portfolio. It is nearly impossible to say anything in finance with certainty. However, it is hard to argue against the following two statements: 1) there will be bear markets in the future and 2) U.S. stocks will not always rule the roost.

At BWFA, valuation is a key element in our investment process. In 2014, it was a difficult time for investors in foreign stocks. Underperforming asset classes often present opportunity. Taking a contrarian view can be difficult, and the payoff is rarely immediate. If you buy low, you have to be willing to tolerate bad news, especially in the beginning. But, over the long haul, buying high-quality assets at a discount should benefit returns. Over time, investing where valuations are lower has yielded far better results than investing where they are highest. While there are many reasons to be concerned about the international economic environment, we believe that those who invest in such areas will end up being rewarded for their patience.